Aiming to ease insurance headache

Tuesday 26 June 2012 11:42 BST

Lord Leverhulme, the soap magnate of an earlier era, once remarked that he knew half the money he spent on advertising was wasted but he did not know which half.

One might well say the same of risk management, particularly in the financial sector. The sums spent are eye watering, but the disasters still come round so regularly that you have to wonder how much of the money is well spent.

Today, a consultation document has been published by the Law Commission which opens up a whole new can of worms — new at least to the boards of public companies. Non-executive directors of large quoted companies might think they have enough to worry about but the message from this report is that there is a fair chance the insurance policies on which their company relies are not legally watertight. In the event of a disaster their business will probably collect far less than expected; indeed it might well be so much less that the firm is forced to close.

Some might consider that a pretty big risk. But very few boards have the skill, expertise or the awareness to check the detail of insurance policies — it is not what boards do. More to the point, they rarely get anyone else to either. The Law Commission report has come about because relations between insurance companies and policyholders are mainly governed by the Marine insurance Act of 1906 and a few years ago someone noticed the business world had changed a bit since then so perhaps it should be brought up to date. But this report is for consultation not legislation. It could yet gather dust in Whitehall.

Today’s document draws heavily on a report by Mactavish, an independent insurance research boutique which has been a long-standing advocate of reform. The main problem is the law states that before taking out insurance, a client must disclose to the insurance firm everything the insurer feels it ought to know. If it fails to do this, the insurer can void the policy and refuse to pay a claim. But in the modern world such a level of disclosure is unrealistic, if not impossible.

These days, large businesses usually have customers and suppliers stretched across the globe, so it is doubtful whether anyone could collate everything an insurer with hindsight might claim he should have been told.

After the floods in Thailand last year London insurers were getting claims from Canadian companies who had been let down by South African suppliers who could no longer get an essential component from Japan because the manufacture there had quietly been sub-contracted to Thailand, whose factory had been washed away. How could any insurance buyer realistically document such complexity across tens of thousands of contractors and sub-contractors?

But the law as it stands is too heavily loaded in favour of the insurance firms. Just one omission, even if it has nothing to do with the problem, can void the entire contract and therefore any claim. An insurer can refuse to pay for flood damage because a promised burglar alarm was not installed.

Ironically, the reason this has become such a big issue is — at least in part — because seven years ago the Financial Services Authority insisted that insurers become more efficient and issue policy documents on the date the policy started. Before then, astonishing though it may seem to the outside world, almost none did. It could be months before the client got the documents; indeed there were cases where the policy had not been issued before the year to which it related was over.

What this meant was that often after a disaster happened, a claim would be made before the policy was issued.

This made it hard for insurers to argue that some risk or other was not covered and refuse to pay. But now, at least according to their customers, the first thing they do is reach for their lawyers and then use disputes about non-disclosure and threats to void the contract as a lever for negotiation. Insurers deny this but with rates under pressure and reserves running down, the climate is much more legalistic than it was and in many cases the client settles for much less than it had expected. This was probably not the outcome the FSA had in mind.

It is seldom an even-handed negotiation. Banks used to help out companies and advance them loans while they waited for the insurer to settle. These days there is no such easy credit. Companies frequently face bankruptcy if they don’t do a deal, however disadvantageous, within a short period of time. It is a case of taking what’s on offer or fighting on for years. Eurotunnel is still negotiating over its 2008 fire.

The Law Commission wants changes made so that the process is more even handed. Companies will still be obliged to provide information they reasonably should know, but insurers should be under an obligation to know what to ask for, and to have a sense of proportion if something is left out. There needs to be an appraisal of the importance and relevance of any omission, so a whole policy cannot be cancelled over something relatively trivial.

The aim of the proposed reforms is that insurance agreements should reflect the modern world and deliver certainty of outcome. It makes huge sense. But one should not underestimate the shock these ideas will be to a lot of insurance companies, brokers and buyers. Or the upward push it will put on prices.

Meanwhile, non-executive directors have something else they really do need to worry about.